Market Commentary - February 2021

Monthly Update

Stock market returns in February followed a similar pattern as they did in January, where stocks started off strong and ended weak. In January, that late month weakness more than offset the early month strength. However, in February, the early month strength was not enough to offset the 2^nd half of the month selling. The most notable area was in US Treasuries and high quality bond markets around the world. Notwithstanding the central banks’ desire for continued low rates, long bonds started to tighten policy for them via higher rates as anticipation of the mass rollout of vaccines grew and inflationary pressures increased.

Contributing to the inflation that bonds are worried about was the 9.3% rally in the CRB commodity index after a 3.8% rally in January, a 4.8% rise in December and a 10.6% spike in November[1]. As of this writing, the index is just off the highest level since October 2018[2]. Also, major supply chain disruptions, product shortages, labor issues, and skyrocketing transportation costs add to the inflation story.

The markets are also looking at the Democrat controlled Washington DC which is on the cusp of passing a spending bill close to $2 Trillion shortly after a December bill totaling $900 Billion. With an economy that is expecting GDP growth of 10% in Q1 (according to the Atlanta Fed’s GDPNow tracker) the bond market is getting worried about the possibility of “overheating” and the inflation that could result.

The vaccine rollout has been bumpy for sure, but we are now close to vaccinating 2 million people per day and we just got news that Johnson & Johnson’s one shot vaccine got Emergency Use Authorization which gives us three options for vaccines. This provides a lot of reason for optimism that life will get pretty close to normal by late spring and into the summer. For example, we have baseball stadiums announcing they will accept fans as well as basketball and hockey arenas.

Lastly, I talked about the Reddit mania stocks in our January letter and they’ve since crashed, not surprisingly, back close to earth. They are not fully back because they are still higher than where they stood before Reddit took hold of them. Manias usually end the same way, mostly back to where they started. This one was made to seem like it was something new but was instead just a different form of what we have seen since the history of modern economies.

US Treasuries 

The Federal Reserve has direct control of the short end of the yield curve as they can pin the overnight fed funds rate to where they want it to be, currently at 0-.25%. Via quantitative easing, they can attempt to manipulate interest rates further out on the yield curve, this time out to about 5 years. What they have much less control over is the part of the yield curve beyond 5 years. What we saw in February was the bond market reasserting its control over interest rates as the 10 year note yield jumped by 34 basis points to 1.41% after rising by 15 basis points in January[3]. That yield was the highest since February 2020[4]. The 30 year bond yield was higher by similar amounts and maybe most importantly, the 5 year yield, very much under the thumb of the Fed, also jumped 31 basis points to .73%[5].

While I said the bond market took control of the Treasury curve, we can also say as a corollary, the Fed has lost some control. It is not a situation they are familiar with outside of the taper tantrum in 2013, which they triggered themselves. This time is notwithstanding their desire to keep rates at zero for years and maintain the current pace of QE.

Reflecting the fact that the rise in rates was a global event, the Aussie 10 year yield jumped a whopping 79 basis points to 1.92%, almost double where it closed in December[6]. This was even as the Reserve Bank of Australia has its short term rate at .10% and initiated QE. The 10 yr Japanese JGB yield, which is essentially pinned to zero via Yield Curve Control, rose by 11 basis points to .16% which is the upper end of what they will allow[7]. It was yielding .02% at the end of December[8]. Shifting to Europe, the UK 10 year gilt yield rose to .82% from .33% at the end of January and .20% at the end of December[9]. The German 10 year bund yield was higher by 26 bps to -.26%, the least negative since March 2020[10].

I believe the Federal Reserve and other central banks have three choices in how to react.

1) They can fight the move and increase the pace or frequency of their QE purchases of bonds

2) They can acknowledge what the markets are telling them and become less dovish

3) They can do nothing and hope this bond market reaction calms down.

What we’ve seen over the past week is some are choosing number one, others number two, and based on speeches recently given the Fed is seemingly going with number three.

Stocks 

It was the jump in interest rates that drove the global stock selloff in the 2^nd half of February where the last two weeks of the month saw the S&P 500 fall in 7 of 9 trading days[11]. While some argue that rates are rising for the right reasons, a better economy helped by the vaccines, it does negatively impact market multiples, particularly the high multiple stocks and sectors such as technology.

I said going into the year that forecasting the direction of the economy and earnings in 2021 will be much easier than figuring out what the right P/E multiple should be. I think that will be more crucial than ever with this rise in interest rates.

Commodities

I mentioned the CRB index above as the broad metric of commodities. The index includes everything from crude oil and natural gas to copper, corn, soybeans, wheat, aluminum, gold and silver. Looking deeper under the hood, the CRB raw industrials index, which includes many commodities that are not publicly traded in the futures market, rose to the highest level since September 2011[12]. The CRB food index is at a level last seen in October 2014[13]. This move up was reflected in the TIPS market where inflation breakevens also rose to multi-year highs.

The 5 year inflation breakeven measures the implied inflation rate the market expects to average over 5 years. It has risen to just below the highest level since July 2008, when crude oil touched $140 a barrel versus being around $60 today[14]. It currently stands at 2.45% and was up 20 basis points in February after rising 25 basis points in January, and 27 basis points in December[15]. The metric 10 years out has risen more modestly to 2.15%, up 5 basis points in February and a combined 30 basis points in the two prior months[16].

We can attribute this rise to broad supply/demand imbalances after years of underinvestment impacting the supply side and strength in manufacturing plus the vaccines helping the demand side. This is not quickly alleviated as it takes time to bring projects on line that can bring more supply.

Washington DC

The likely passage in coming weeks of another $1.9 Trillion of Federal government spending is feeding fears of higher inflation and economic overheating. While many need the financial help, much of the spending is not for Covid relief. The rising debts and deficits are really becoming astronomical with the former now at around $28 Trillion for the Federal Government and the budget deficit at 16% of GDP as of January 31^{st [17]}. This is not free just because interest rates are still low because they are less low and we have a weak US dollar as well as rising inflation now.

US Economy

With now three vaccines being rolled out, we have a lot to look forward to in terms of an acceleration in economic activity in the coming quarters, particularly in the services sector. Most affected will be travel and leisure with bars and restaurants especially big beneficiaries. This economic strength will be enhanced by the high savings rates that consumers have maintained and which will be augmented by more government transfer payments. The question will be to what extent consumers shift their spending away from the goods side which was a Covid beneficiary. Consumers put money into their homes, along with buying new ones, bought cars, electronics, exercise equipment, etc. These are not recurring and is where the shift in spending to services will come from.

Conclusion

There is nothing boring in the investing world and nothing is always intuitive either. In 2020 we experienced a 100 year virus at the same time stocks had a great year. In 2021 we will be benefiting from the incredible pace of medical advancements that brought us effective vaccines in a record time but markets that face a more uncertain outlook because of the change in interest rates we’ve seen in the past few months.

Either way, whatever the outcomes will be, it is vital that investors have a plan that suits their short term liquidity needs over the next 2-3 years. Knowing that period of time is covered can help separate the balance of one’s portfolio from what I believe will be a continued choppy time for the economy and markets. Please do not hesitate to reach out at any time with questions or for any discussion on these matters.

Disclaimer